Some Thoughts On The Markets: Gold, Yen, Dollar

There’s a lot happening underneath the surface in the markets right now and I thought It would be worth highlighting a few of these things.

Inflation Expectations Plummeting

Above is the 5yr inflation breakeven. As you can see, the annual inflation expectation has fallen from ~2.10% per year in July to ~1.65% today. This is a substantial drop in expectations. There’s nothing in the current inflation data to indicate that, at the margin, expectations should be plummeting. That being said, the market looks to be somewhat taken off guard by the FOMC’s higher than expected Fed Funds forecast for 2016 & 2017. This “tighter” Fed is driving much of this IMO.

Below is the chart for 5yr real yields. Goes without saying, but falling breakevens & rising nominal yields have caused real yields to shoot higher. As shown in the chart, 5yr real yields at 15bps are at their highest level in over 3 years.

Dollar rising

This is a surprise to nobody, but the dollar has been on an absolute tear with the DXY rising from 80 to 84.72 since July, but the move is actually fairly small in a longer historical perspective. The US economic cycle is much further ahead than other developed economies right now. In the US there’s actually discussion about a rate hike while other places such as Europe the discussion is centered around further easing & fighting deflation.

Yen Weakening

The dollar strength has been broad based and has also included the Yen. The USDJPY has resume its upward climb and stood over 109 as of this morning. At current levels there’s a substantial gap in inflation expectations between the two economies. In Japan 5yr inflation breakevens are ~2.3% while as discussed, in the US, they are at ~1.65%. There’s been a lot of promises from Abe and the BoJ, but I am skeptical of this inflation materializing.

As of 6/30/14, Japan’s current account balance moved to negative 0.12% of GDP after being positive for the last 20+ years. Part of this is the fact that Japan has had to import high cost energy after having to take the nuclear reactors off line. If/when the nuclear power comes back, this should materially help Japan’s current account deficit and may potentially be a tailwind for Yen appreciation.

Gold

The chart of gold looks pretty bleak but I think there’s a number of reasons for this. Many of the “memes” that gold bulls have pointed to are now gone or are coming to an end. QE, which some erroneously coined as “money printing” and inflationary, is coming to an end. Second, inflation is low and inflation expectations have plummeted as shown above. Third, the dollar has materially strengthened. Now this doesn’t mean that gold can’t go up, or won’t go up, but many of the reasons commonly cited by gold bulls have now gone by the way side.